Doug Noland: The Solvency Problem

Michael Bond comment: We need a wartime economic response to save Americans, not a preserve-the-wealth-at-bubble-levels response. We are not going to achieve either. The rescue bill was about preserving wealth with no transparency while providing 1/10th what is needed to bridge the economy to the other side.


Being an analyst of Credit and Bubbles over the past few decades has come with its share of challenges. Greater challenges await. I expect to dedicate the rest of my life to defending Capitalism. One of the great tragedies from the failure of this multi-decade monetary experiment will be the loss of faith in free market Capitalism – along with our institutions more generally.

Somehow, we must convince younger generations that the culprit was unsound finance. And it’s absolutely fixable. Deeply flawed, experimental central banking was fundamental to dysfunctional markets and resulting deep financial and economic structural impairment. The Scourge of Inflationism. If we just start learning from mistakes, we can get this ship headed in the right direction.

Over the years, I’ve argued for “rules-based” central banking that would sharply limit the Federal Reserve’s role both in the markets and real economy. The flaw in “discretionary” central banking was identified generations ago: One mistake leads invariably to only bigger blunders.

What commenced with Alan Greenspan’s market-supporting assurances of liquidity and asymmetric rate policy this week took a dreadful turn for the worse: Open-end QE, PMCCF, SMCCF, MMLF, CPFF, MSBLP, TALF… They’re going to run short of acronyms. Our central bank has taken the plunge into buying corporate bond ETFs, with equities ETFs surely not far behind. The Fed’s balance sheet expanded $586 billion – in a single week ($1.1 TN in four weeks!) – to a record $5.25 TN. Talk has the Fed’s new “Main Street Business Lending Program” leveraging $400 billion of (this week’s $2.2 TN) fiscal stimulus into a $4.0 TN lending operation. Having years back unwaveringly set forth, the ride down the slippery slope of inflationism has reached warp speed careening blindly toward a brick wall.

[Bernanke is the former Federal Reserve Chairman who printed trillions to bailout wall street in post 2007. He’s a dangerous idiot]

Ben Bernanke, appearing on CNBC, March 25, 2020: “Low interest rates are not – and I know some of you will be skeptical – but it’s just a fact that low interest rates around the world are not primarily a monetary policy phenomenon. Interest-rates around the world have been declining since the eighties. And if you look at the 10-year Treasury yield since 1980 from then till now – 40 years – it looks like a ski slope. The rate just keeps coming down and down and down. And as I’ve talked about before, I think what we have in the world now is a global savings glut. Longer life spans, rising incomes and for a variety of reasons there’s a lot of savings in the world. Any asset manager will tell you that – and it’s hard to find good uses for that money – hard to find good capital projects. Even when monetary policy is at a normal level – and we got pretty close to a normal level when the Fed was raising rates earlier – interest-rates are going to be much lower than in the past. So low interest rates are something we’re going to have to live with for a while very likely. And we have to be very alert about financial risk. The Fed is looking at that at much more detail than we used to. But, again, it’s not a monetary policy thing. It’s a long-term trend.”

The Fed “very alert about financial risk”? What exactly has the Fed been “looking at at much more detail”? Financial excess? Speculative leveraging? Mounting vulnerabilities in the derivatives complex, the ETF universe, corporate leverage? Global hedge fund leverage? Highly levered mortgage companies? We’ve now witnessed two historic bouts of market illiquidity and dislocation – exposing massive speculative leveraging – and Dr. Bernanke sticks resolutely with his “global savings glut” thesis. Central banks have during this cycle created more than $16 TN of new “money,” for heaven’s sake. Of course it’s been “a monetary policy thing.”

I’ve always viewed Bernanke as a decent man. But as a central banker – as the mastermind for the terminal phase of a runaway global monetary experiment – he’s been a disaster. His analytical framework is so flawed it’s difficult to comprehend the amount of power and discretion placed in his hands. It was Bernanke that invoked the government printing press to resolve whatever might ail the markets or economy. His crackpot theories that the Fed’s failure to print sufficient money supply after the ’29 stock market crash caused the Great Depression should have been sternly rebuked years ago. Worst of all, Dr. Bernanke specifically used the risk markets (stocks, corporate Credit, derivatives and such) as the primary mechanism for post-Bubble system reflation. The former Fed chief is the father of “QE,” “helicopter money,” and the ETF complex that took the world by storm.

Documenting for posterity the ever-lengthening list of lending facilities, this week from the Federal Reserve:

“The Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.”

“The SMCCF will purchase in the secondary market corporate bonds issued by investment grade U.S. companies and U.S.-listed exchange-traded funds whose investment objective is to provide broad exposure to the market for U.S. investment grade corporate bonds.”

“The Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit.”

“Facilitating the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities.”

“…A Main Street Business Lending Program to support lending to eligible small-and-medium sized businesses, complementing efforts by the SBA.”

“The TALF is a credit facility authorized under section 13(3) of the Federal Reserve Act intended to help meet the credit needs of consumers and small businesses by facilitating the issuance of asset-backed securities (“ABS”) and improving the market conditions for ABS more generally… The TALF SPV initially will make up to $100 billion of loans available.”

The Fed was to expand its assets by at least $625 billion this week. In concert with global central bankers, unprecedented liquidity operations coupled with a massive U.S. fiscal program was sufficient to reverse collapsing global markets. Once reversed, there was more than ample fodder from the reversal of short positions and market hedges to power a historic market spike (“biggest three-day surge since 1931”).

Chairman Jay Powell, appearing Thursday on the Today Show: “There’s nothing fundamentally wrong with our economy. Quite the contrary. The economy performed very well right through February. We’ve got a fifty-year low in unemployment for the last couple years. So, we start in a very strong position. This isn’t that something is wrong with the economy.”

Powell’s optimism was echoed by regional Fed presidents: Dallas’s Robert Kaplan: “We were strong before we went into this, and we believe that we’ve got a great chance to come out of this very strong.” Atlanta Fed President Raphael Bostic: “The economy started at a great place.”

The Fed believes it has “temporarily stepped in to provide loans” – for a system considered fundamentally sound and robust. I am an analyst and not a pessimist. But, most unfortunately, the opposite holds true. U.S. and global economies were unstable “Bubble Economies” fueled by Credit and financial excess, most notably by unprecedented asset market speculative leverage. Fed assets surpassed $5 TN this week, and I’ll be stunned if they ever again fall below this level. I am reminded of Fed officials having actually expected in 2011 that its “exit strategy” would return the Federal Reserve balance sheet to near pre-crisis levels – only to double assets again in about three years to $4.5 TN.

The Austrian “Bubble Economy” concept will be invaluable as we analyze dynamics going forward. From the economic perspective, a decade of ultra-loose financial conditions incentivized businesses to over-borrow – from multinational corporations, to mid- and small business to sole proprietorships. Tens of thousands of unprofitable (and negative cashflow generating) enterprises proliferated throughout the economy – from Silicon Valley “tech Bubble 2.0,” to shale, alternative energy, biotech, media, entertainment and leisure, and so on. Ultra-loose financial conditions stoked over- and malinvestment, while generally distorting business spending patterns. Confounding post-Bubble financial and economic landscapes will create investment decision mayhem.

U.S. and global economies are severely maladjusted – and ravenous Credit gluttons. Importantly, this ensures Trillions of monetary stimulus along with Trillions of fiscal spending will be absorbed as if dumping buckets of water onto the scorching desert sand.

Stimulus will for a time sustain scores of uneconomic enterprises, at the cost of prolonging the workout process. Nonetheless, with Bubbles popping in shale, technology, leisure and entertainment and elsewhere, millions of job losses will prove permanent.

Negative wealth effects will also wreak havoc on consumer spending patterns. From the Fed’s Z.1 report, Household Net Worth (Assets less Liabilities) ended 2019 at a record $118.4 TN, having ballooned $23 TN, or 21%, over the past three years. Household Net Worth ended 2019 at a record 545% of GDP, up from previous cycle peaks 492% (Q1 2007) and 446% (Q1 2000). Household holdings of Equities (Z1: Equities and Mutual Funds) ended Q4 at $30.8 TN, a record 142% of GDP (up from 2007’s 102% and 2000’s 117%).

Now comes the downside. Easy gains from asset inflation are spent more freely than incomes. Changing spending patterns will expose the fragile underbelly of the “services” and consumption-based U.S. economy. Meanwhile, some of the most expensive real estate markets in the country will suffer collapsing demand, with major effects on construction, spending and confidence (not to mention loan losses).

One of the many lasting pandemic consequences will be a reassessment of living in New York City, San Francisco, Los Angeles and other densely-populated urban centers. Beyond negative asset market wealth effects, I expect a prolonged impact on high-income earners (i.e. Wall Street compensation, executive pay, company stock rewards, Silicon Valley, entertainment and media, real estate-related, etc.). Expect some upper-end real estate Bubbles – having persevered even through the last crisis – to finally succumb. The bursting of an unprecedented nationwide commercial real estate Bubble will have major impacts on construction and the finances of owners of real estate, as well as on the underlying loans, securitizations and derivatives.

Every segment of the economy will be impacted – many deeply. Expectations for a quick recovery are wishful thinking. And I doubt it will be possible for the Fed and global central bankers to step back from market liquidity support operations. We should not be surprised by ongoing weekly Fed balance sheet growth of several hundred billion. Household, business and market confidence have been shaken – and will be slow to recover. Markets have been conditioned over recent decades to anticipate rapid recovery. Confidence was bolstered this week by incredible “whatever it takes” measures. I’m just not convinced the necessity for ongoing rapid central bank expansion will prove as confidence inspiring.

New York state reported its first coronavirus infection on March 1st. In less than four weeks, cases multiplied to 45,000. From the February 22nd CBB: “Cases tripled to nine Friday in Italy, with the first death reported.” Italy reported 919 deaths Friday, with total deaths of 9,134 and cases of 86,498.

Governments have made very unfortunate missteps managing this pandemic. Many now look to the trajectory of China’s outbreak for hope that cases elsewhere will begin declining soon – with economic normalization commencing in earnest. Yet Western democracies have a major disadvantage in managing a pandemic. Societies would not tolerate health authorities going door to door checking for symptoms and removing those with fevers (sometimes kicking and screaming) for immediate transport to isolation facilities.

One has only to view photos of a bustling Central Park or videos of crowded NYC subways to realize that “lock down” means something quite different in the U.S. than it does in Wuhan and Hubei Province. And only China has 170 million cameras and a sophisticated surveillance system – that in one case provided the ability to track an infected individual “down to the minute” as he traveled between provinces and along public transit in Nanjing.

Bill Gates’ comments (CNN Coronavirus Townhall, March 26th) resonated. Having warned of pandemic risk in a 2015 TED talk, and after years of being fully immersed with the Bill and Melinda Gates Foundation’s efforts in infectious disease control, vaccines and other global health initiatives, Gates possesses deep understanding of the subject matter. His view is that nationwide shutdowns and social distancing efforts must be strictly maintained until the number of active coronavirus cases declines to a low and manageable level. A cursory glance at one of the nationwide outbreak maps is sufficient to appreciate that the outbreak is currently out of control throughout the country.

We’ll learn more next week, but it appears the White House is moving forward with a plan to gauge the outbreak across the country in a county by county effort to get the economy moving back toward capacity as soon as possible. It’s difficult for me to see governors, mayors, local government officials and vulnerable healthcare systems around the country supporting any relaxation of pandemic management efforts.

Unfortunately, there will be no speedy economic recovery. Let’s hope the change of season offers some relief. But then there’s the loaming prospect for a second wave next fall and winter. Various experts, including Bill Gates, say a vaccine is a year to 18 months out. There’s going to be a hell of a battle in deciding how best to move the economy forward from here.

As for the markets: markets will do what markets do. And global market dynamics are incredibly unsound. Count me skeptical that the biggest three-day rally (in the DJIA) since 1931 is a sign of health. I fully appreciate that “buy the dip, don’t be one” has been richly rewarding for a long time now. “There couldn’t be a better time to start investing [than] right now… Fortunes are going to be made out of this time… I can guarantee you that if you stay in and you just stick with it, three years from now you will be very, very happy that you did.” I’d be especially cautious with guarantees. Suze Orman (and most) have little appreciation for what is now unfolding. The younger generation has yet to experience a grueling protracted bear market. “Buy the dip” and “buy and hold” are poised to dishearten.

Incredible central bank liquidity operations yanked global markets back from the precipice. In the three sessions, Tuesday to Thursday, the Dow surged 21.3% (ending the week up 12.8%). The week saw the S&P500 rally 10.3%, lagging the Japanese Nikkei’s 17.1% surge. Brazil’s Bovespa recovered 9.5%, as emerging equities bounced back. Mexico’s peso rallied 4.6%, leading an EM currency recovery. In “developed” currencies, the Norwegian krone rallied 11.6%, in another week of acute market instability.

After spiking 44 bps the previous week, investment-grade Credit default swaps (CDS) this week sank 40 to 112 bps. The iShares investment-grade corporate bond ETF (LQD) surged 14.7%, more than reversing the previous week’s extraordinary 13.3% decline.

The Fed’s move to open-ended QE coupled with corporate bond and bond ETF purchases was instrumental in arresting market collapse and sparking upside dislocation. This, along with expanded central bank swap arrangements, reversed global market illiquidity and panic.

If I believed global markets were chiefly facing liquidity issues, I would be more hopeful. Illiquidity was pressing, and global central bankers responded with “whatever it takes” (and it took a lot). Believing the global Bubble has burst, I see the overarching issue more in terms of a developing Solvency Problem. Burning the midnight oil in homes around the globe, rating agency employees enjoy enviable job security. And that would be Credit analysts for corporations, financial institutions, municipalities, investment-grade bonds, junk debt, structured products and nations. Credit and Solvency issues will turn systemic.

It’s a different world now. And while “whatever it takes” can accommodate speculative deleveraging and generally support market liquidity, The Solvency Problem will prove a historic challenge. The global economy has commenced a major downturn, hitting an already impaired global financial system. While markets enjoyed a recovery this week, EM debt is turning toxic. Energy-related debt is already toxic. Risk of general business and real estate debt turning toxic is growing rapidly.

As I posited last week, I see an environment hostile to speculative leverage. This ensures a fundamental tightening of financial conditions and attendant downward pressure on global asset markets – securities and real estate, in particular. And with Bernanke’s 40-year bond yield “ski slope” at the end of a historic run, central banks have today little capacity for using rate cuts to reflate asset prices.

The U.S. economy is in trouble. Europe is in greater trouble. EM economies face a disastrous combination of financial and economic hardship. And just as China moves to restart its economy, the massive Chinese export sector is confronting collapsing global demand. How long Beijing can hold things together is a critical issue. In the theme of bursting Bubble economies and unfolding Solvency Problems, no country faces greater challenges than China (with its deeply maladjusted economy and gargantuan financial sector).

March 26 – Bloomberg (Matthew Boesler): “The Federal Reserve’s balance sheet topped $5 trillion for the first time amid the U.S. central bank’s aggressive efforts to cushion debt markets against the coronavirus outbreak through large-scale bond-buying programs. Total assets held by the Fed rose by $586 billion to $5.25 trillion in the week through March 25… Borrowing by banks from the Fed’s discount window jumped to $50.8 billion. The central bank has rolled out several liquidity programs over the last few weeks to keep credit flowing… The scale of its current bond-buying efforts already dwarfs that of the purchase programs it undertook in the wake of the last financial crisis. The Fed is also expected to establish a Main Street Business Lending Program to provide help to smaller firms. Borrowing under its Primary Dealer Credit Facility was $27.7 billion as of Wednesday, with the Money Market Mutual Fund Liquidity Facility standing at $30.6 billion. Borrowing by foreign central banks soared to $206 billion — the highest since 2009 — following the Fed’s March 19 announcement that it would expand dollar swap lines to a larger group of nations.”

Original Post 28 March 2020


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Categories: Doug Noland, Perspectives